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Our primary writer is a weatherbeaten veteran of the Rodent Wars, where he became highly decorated for the destruction of many vicious rodents. Now that he is retired, he sneaks onto his blog every night and writes about world events.

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Tuesday, May 6, 2008

Oil Pricing Driven by Pundits

As of today the price of oil is exceeding $120 per barrel. It is tempting to blame this completely on the greed of the oil companies. But, if this is such a profitable business, then why aren't people starting up new oil companies to provide cut-rate gasoline to everyone. I know that I would surely buy at a station that sold gasoline just 10 cents cheaper than the other stations. But the real causes of the high price of oil and of gasoline are much more complex.

First of all, we have the supply of oil. Bringing large new flows of oil into our system is a decade-long process. First, people have to explore for oil using seismic sensing and the other tools of the geologist. Then, test wells must be drilled to determine if there really is oil in suspected fields. Then, multiple wells must be drilled. If this is near an existing field in a developed area, this may not be a problem. But increasingly new oilfields are located in remote areas on land, in the Artic, and at sea. In these cases, not only must the wells be drilled, but roads must be created, pipelines laid, huge drilling platforms must be built (which takes years) and permits must be secured (which may never come.) The process of developing oil for the market takes years and years.

Then, we have demand. Both India and China's economies have hit a critical point in the last 5 years. Both of these huge countries have reached the point where there has been a surge in the membership in the middle class. No longer do people in these countries live a rural, subsistence existence. Instead, manufacturing and service jobs are multiplying at double-digit rates, bringing hundreds of millions of people to the point where they can afford modern Western-style homes, electrical appliances, and cars.

And it is not only China and India. Brazil is rapidly growing. Russian is turning the corner. Turkey is modernizing. Iran is modernizing. Korea is now a full member of the Internet Age, with a standard of living nearly equal to Japan. The other "Tigers" of Asia - Singapore, Malaysia, Thailand, Taiwan, Hong Kong, and the Phillipines - are nearly completely integrated into the world economy. Mexico is moving forward rapidly, and the Arab states are now building the world's tallest buildings. Vietnam is coming out of its isolation. The Third World is rapidly shrinking as more and more countries become workshops for other countries. And the effect is a tremendous growth in the demand for consumer goods, good food, and energy.

Oil demand is pushing supply. Formerly, Saudi Arabia had a surplus of some 4 million barrels a day capacity. Now, that surplus is measured in hundreds of thousands of barrels a day. But there is an even more important cause of this price rise.

When Europe finally developed a single currency a few years ago, it had a tremendous impact upon the costs of moving goods and services from country to country inside Europe. Suddenly, the cost to the French of buying German products dropped by 5 to 10 % because there was no longer any direct costs to exchanging money - or the indirect accounting costs associated with it. Similarly, French products became cheaper in Germany and the same scenario was played out throughout Europe. Spanish businesses expanded into Italy. Dutch businesses moved into France. American businesses with a toehold in Europe decided to put on a big push. Germans bought luxury homes in Spain. The price of real estate soared. And investors worldwide began to invest in European companies and move their money away from American companies.

To attract investors, American companies began to pay higher prices on their corporate bonds. This effect on interest rates led banks to increase their rates, particularly on variable rate mortgages. The early rise in gasoline prices hit about the same time. People began to default. Investors moved their money out of mortgage-backed securities. The housing market began to slow. Investors now had another reason to move their money to European investments.

The dollar began to fall rapidly in value. Slowly at first, then rapidly, the dollar was able to buy less. This also applies to oil. Now, the supply and demand equation for oil isn't that important. Instead, the value of the dollar is more important. And as the rising price of oil slows down the US economy, interest rates continue to fall in the US, making investments in Europe more and more attractive. When will it end?

This sort of swing has happened before. However, with the spread of the Internet and sources such as the Drudge Report, Bloomberg, and the ability of Americans anywhere to read the Financial Times, the oil market has become a roller coaster, driven by rumors and emotion. And thus, the only way that things will change is for the emotion to change.

Around the end of April, it looked like the Fed and others were making a concerted effort to change the emotions. Predictions were being made of the immediate rise of the dollar. But to no avail. When will the dollar turn?